What Makes Incentives and Compensation So Tricky?
Written By: Predrag Jakovljevic
Published On: November 29 2006
Managing incentive compensation presents challenges to almost every large and midsized company, due to the complex nature of the calculations. Such calculations might involve determining whether the sales plan is to pay on profit, or rather pay on market share; whether it involves multiple payees per transaction, etc. Other considerations include the high levels of security required (owing to the numerous and diverse authorization levels, and the fact that data feeds are coming from many external data sources), and the dynamic nature of the sales environment that imposes the need for visibility of millions of report pages per week containing all pertinent sales, customer, and corporate data. Further complicating these considerations are intensive integration of divisions, legacy systems, upstream and downstream connections, and so on. Last but not least, there are also people issues to manage, such as disputes, approvals, reorganizations, and self-service capabilities.
Part Three of the series Thou Shalt Motivate and Reward Workforce Better.
Going deeper into these issues, incentives can be defined in very complex ways, including percentage rate commissions, step rates (whereby incentive rates can be accelerating [an incentive rate that increases after a specific level of performance is attained] or decelerating [an incentive rate that decreases after the attainment of a certain performance level]), and threshold bonuses (the lowest performance level that must be achieved in order for an employee to earn an incentive payment). Other methods include sales promotion incentive funds (SPIFs), which is a loose term referring to an on-the-fly addition to the compensation plan used to motivate the sales force in a particular way by providing additional sales credit or payment for certain types of sales. Also standard are overrides (manual replacements of a value that the system has calculated with another value—for instance, when a person from the bench, for whatever reason, has to come and close a deal for someone who was supposed to do it); draws (cash payment advanced against future income that can be non-recoverable [a guaranteed minimum level of future income] or recoverable [a minimum level of future income that may be recovered from calculated incentive earnings]; draw accounts (usually, an allowance given to sales people working on a straight commission as an advance against commission payments); and many more methods and factors. Incentive compensation can be particularly difficult to calculate for various other reasons:
- Many people can get partial credit for a single transaction; split credits then have to take place when a sale qualifies for inclusion in compensation purposes for one or more employees.
- Territory boundaries can be defined by geography, product, area code, or a myriad of other factors, since territory is a way of defining which transactions a participant should be credited with (it is usually a geographic area, but can also be an industry or a specific set of customers).
- Incentives can also be paid on a rolling basis; at regular intervals (quarterly, monthly, yearly, etc.); or via a customized schedule. In general, an incentive formula represents the mathematical method of ascertaining how pay opportunity relates to performance, and how one pay opportunity relates to another for determining payout.
- Transactions can occur at very high volume.
- Different incentive plans can apply to different job descriptions.
To illustrate the complications of a shared ownership, in complex sales environments one customer may require several salespeople at different stages in the customer's life cycle, but each salesperson must have a personal reward structure. The compensation system must thus be well aligned with the job. For example, one provider of medical imaging products found that rewarding salespeople and field engineers separately for their specific role in the sales cycle not only improved performance, but also boosted incremental sales. Hence, its sales professionals are now compensated for selling the imaging systems themselves, since its field engineers, deployed remotely, are in the best position to sell extended contracts as customers approach the end of their original warranty period. The field engineers are rewarded separately for customer retention efforts when they sell extended contracts, or cross-sell or up-sell other products. As a result of the compensation strategy and the software to support it, the company has seen an increase in contract renewals, and it can renew contracts faster, eliminating any lapse in coverage.
For background information on incentives and compensation see Thou Shalt Motivate and Reward Workforce Better, and Are Sales Incentives Even in tune with the Corporate Strategy?.
Thus, an astute performance and incentive compensation management solution should solve these calculation challenges by providing a rule-based system that can perform the following functions:
- Divide the compensation calculation process into four logical steps:
Maintain complex territory definitions.
Assign credit to multiple parties, as defined by the company's sales compensation plans.
Model and deploy, via a rules engine, the most complex of compensation rules and plans.
Create multidimensional and multicurrency look-up tables to help maintain control over sophisticated calculations.
Maintain a highly flexible assignment methodology that ensures each payee is covered by an appropriate compensation plan.
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As mentioned earlier, visibility and transparency are key requirements, both to the people being paid, and to the companies that are paying. In addition, new legislation also demands unprecedented transparency for corporate financial records, starting with the US Sarbanes-Oxley Act (SOX) requiring tighter controls and visibility into all financially significant business processes (including incentive compensation). Furthermore, transparency and disclosure of broker commissions, as well as the ability to track whether the channel is meeting the required evolving licensing and educational requirements, is a critical issue in the insurance industry. In general, third party sales representatives require detailed compensation information to maintain loyalty, while shareholders insist on clearly stated returns on investment (ROIs), such as sales performance obtained through incentive compensation. Therefore, the appropriate solution has to provide the visibility that companies need by establishing tight process control over incentive compensation, and then make appropriate information available for review through a reporting application. Such information is used to provide payees with detailed information about their goal attainment and related compensation, as well as to provide managers with the information they need to make decisions about their incentive compensation investments, and visibility into the incentive compensation process to all parties involved.
Dispute resolution challenges arise out of constant changes to territories, organizational changes, miscoding of sales transactions, or other timing issues that cause transactions to be credited to the wrong payee. As mentioned earlier in this series, if not dealt with quickly and effectively, compensation disputes can cause loss of morale among the sales force and distributor network; loss of direct sales, third party brokers, and dealers to competitors; overpayment of compensation to undeserving parties; administrative bottlenecks that draw resources away from more important tasks; and overload on information technology (IT) resources devoted to the research and resolution of disputes. Again, a proper solution has to speed automatic resolution to compensation disputes by leveraging the vast store of knowledge in the compensation repository to research the validity of claims for compensation. It should then intuitively present the results of its research, and in many cases, present a recommended resolution for the dispute. Such a nifty application can not only produce significant savings in overpayments, as well as in countless hours of administrative and IT time, but also improve relations between compensation departments and their sales people, along with third party brokers and channel partners.
Adding to the complexity are tremendously high transaction volumes (with millions of transactions, thousands of payees, and millions of dollars paid per period) across a broad product portfolio, and a diverse sales network of direct sales (field sales, sales managers, sales engineers, and internal sales) and channels (partners, independent agents, retail stores, brokers, dealers, value-added resellers [VARs] and other third parties), as well as requirements for audit trails and corporate governance. Consequently, incentive compensation can be difficult to manage because organizational changes occur and are unpredictable; territories change; personnel get re-assigned; brokers enter or leave the network; market conditions change (requiring new incentive strategies); and organizations merge (thereby combining different compensation plans and cultures into a single company).
As indicated earlier, such companies need to model or project the cost of compensation pay in order to tackle the major business challenges of planning, budgeting, and forecasting. Namely, as companies move beyond the midpoint of a given fiscal year, executive and sales management often wonder how different market-driven compensation plans would have performed. Executives may want to take the company's actual revenue and transactional results and track them against proposed compensation plans, in order to see how much more or less they might have cost in incentive pay. But, as companies enter the latter part of a fiscal year, then they need to start designing compensation plans for the following fiscal year. They must be able to design hypothetical compensation plans and run hypothetical revenue and transactional scenarios against them, to ensure that the projected cost of compensation is within budget guidelines. Finally, once companies are in a new fiscal year and compensation plans are in place, they need to forecast the cost of compensation on a regular basis (typically monthly). Companies take the compensation expense forecast and book it as an accrual on their income statements.
This is a shift away from the broken ritual of the annual budget, whereby traditionally, budget forecasts and analyses were made once a year; nowadays, those figures need to be constantly updated. Yet, most organizations do not have the data or the tools required to effectively model incentive compensation for planning, budgeting, and forecasting, and must rely on inaccurate data to come up with cost projections. Furthermore, for most companies, the ability to model even simple adjustments is arduous, and the ability to fully assess the impact of annual changes or the common mid-year tweak is virtually impossible. As a result, actual compensation expense can vary drastically from budgets and forecasts, thereby impacting earnings per share and stock price.